Building for the Future

By

Dimitra DeFotis

Updated May 21, 2007 12:01 am ET / Original Sept. 15, 2019 6:15 am ET

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USG, THE LARGEST NORTH AMERICAN maker of wallboard, has survived several hits from the wrecking ball. The company was pushed to seek bankruptcy protection in 2001 by the rising costs of asbestos litigation, only to emerge last year just as the housing market peaked. As new-home construction tanked, earnings fell to $8.85 a share, from $11.01 in 2005. This year and next,
USG
will be lucky to earn $2 a share, which helps explain why its stock price has plummeted by 48%, to 48.

Yet USG (ticker: USG), which makes and markets a wide range of building materials, could prosper mightily when the housing cycle turns. While 45% of its 2006 revenue of $5.8 billion was tied to new-home sales, 15% derived from residential remodeling and 40% from commercial construction -- both markets that continue to grow. In addition, USG is reducing wallboard output, developing new lines of business such as ceiling products, and enhancing its distribution system through savvy acquisitions. Not least, it is switching manufacturing to newer, low-cost facilities from older, less efficient plants.

John De Gan, chief investment officer of Harbor Advisory, says these and other moves will give the company "a higher market share with more pricing strength." Harbor has been buying the stock since March. De Gan calculates USG could earn $5 to $6 a share in three years (adjusting for the doubling of shares outstanding a result of an offering to help finance a $4 billion asbestos trust fund). If the stock were to sell again for 15 times future earnings -- its historic average -- it could command a price as high as 90.

USG trades for 25 times 2007 expected earnings. But history has shown the wisdom of buying cyclical stocks at peak multiples, before earnings start to rebound.

The Chicago company, once called U.S. Gypsum, owes a debt to its famous shareholder, Warren Buffett, whose support helped it raise the funds for the asbestos trust. Buffett first bought stock in 2000 and raised his stake last year. He now owns 17%. Buffett and USG have agreed that he must bid for the whole company if his holdings exceed 40% before 2013. Indeed, USG sometimes rallies on rumors that
Berkshire Hathaway
(BRKA) is preparing an offer.

That hasn't happened yet, but other value investors climbed aboard in the first quarter: Ariel Capital Management added 3.4 million shares, Third Avenue Management bought 1.7 million shares and Wallace R. Weitz & Co. took on 1.3 million shares, according to filings. They, too, presumably recognize USG's operating leverage, and expect the stock to discount a housing recovery before it occurs.

The Bottom Line

USG's earnings could rebound to $5 or $6 share in coming years. If the company trades again for 15 times earnings -- its historic norm -- the stock could climb to 90, from today's 40.

USG has fared poorly relative to other building-materials suppliers, such as
American Standard
(ASD),
Masco
(MAS) and
Owens Corning
(OC), in part because of the wallboard market's deteriorating fundamentals. Demand is expected to fall 10% this year, and the company's average first-quarter selling price -- $164.12 per thousand square feet -- was 9% below its average price in '06. USG's Sheetrock brand has become a generic term for wallboard (which accounts for most of its revenue). The company has 30% of the market, ahead of privately held National Gypsum and Koch Industries' Georgia-Pacific.

In a bid to curb price erosion, the industry has shrunk capacity by roughly 20% from peak levels; USG has cut its output by 2.5 billion feet over last year. Yet, price weakness also creates "attractive growth opportunities for us, like acquisitions...in low-cost wallboard-manufacturing capacity," CEO William Foote told investors in April.

USG bought a gypsum-mining and plaster manufacturing company in Mexico, and its low-cost factories are humming. It has also invested $900 million-plus in the past five years to build some of the industry's most advanced production facilities and plans to bring them online in coming years in California, Virginia and Pennsylvania. USG similarly is investing in its fast-growing distribution arm, L&W Supply, which will allow it to boost sales for commercial customers. And it snapped up a California wholesaler in the first quarter that serves seven states and part of Mexico.

Housing bears see no end in sight to the industry's troubles, a view confirmed for many by Wednesday's news that the percentage drop in building permits represented a 17-year low. Yet doom, gloom and the nationwide glut of condos, colonials and McMansions are reflected in many housing-related shares. Either way, USG is likely to wind up a winner, given its thoughtful effort to remodel its own house when times are tough.

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